Most of the people I know who own their homes, have a mortgage. Some of them, such as my colleague, are trying to repay their mortgage as fast as possible. Today I’m going to discuss an alternative to paying off the mortgage by showing you how you could live for free by investing in bonds.
Paying Debt to Increase Security
Paying down your mortgage gives you a lot of security. The security that your home cannot be repossessed by the bank. But it also gives a guaranteed return on your money. You will pay less interest when you accelerate your mortgage pay down, and this is a guaranteed return. Paying off your house will make you live for free.
If you invest in stocks, real estate, and bonds, the returns are not guaranteed. One of two ways to generate a risk free investment return is by having money in a European savings account covered by the EU’s deposit insurance scheme. The other is by investing in European government bonds. US government bonds are also risk free in dollar terms, but you will be exposed to currency rate risk between the euro and dollar.
Government bonds are super secure, especially bonds issued by governments in developed Europe. Countries like Germany, France, The Netherlands will never default on their loans. If they do, we have bigger issues than losing money in our investments. I’m thinking of civil war, famine, etc.
The only downside of government bonds is the extremely low yield. Of course this has to do with the extremely low risks involved (and expectations of low inflation). The yield on Dutch 10 year bonds is currently 0.36% and for German 10 year bonds the yield is 0.22%.
The US 10 year bonds are yielding around 2.70%. This might sound very interesting for EU investors, but mind you, your returns are determined by currency exchange rates!
Mortgages and Bonds
A bond is a loan issued by a borrower, which is a government or company, to investors. A mortgage is a loan, issued by a borrower or home owner, to a bank. A mortgage is a kind of bond. At least, if you are the bank loaning money.
Your Mortgage is a Short Bond!
If you are the borrower (which I suspect you are), a mortgage can be thought of as a negative (or short) bond.
Now we know that a mortgage acts as a shorted bond in your investment portfolio, we can do some thought experiments! When
shorting a bond having a mortgage on your home, you are expecting interest rates to rise. That’s easy, in a rising interest rate environment loans are losing value. The banks gives you money at 2%, then when the interest rates rise to 3% the loan is less valuable to them because they could’ve made more money. For you, the mortgage just became more valuable, as long as you keep your old mortgage you pay less than the market rate.
Value of Bonds
The same logic applies to investing in bonds. If you buy the Dutch 10 year bond mentioned above, you will lock in a return of 0.36% for the next 10 years. What happens if rates start rising, to 2, 3, 5%? You will want to sell the bond as quickly as possible, to be able to invest in higher yielding bonds. Because of this selling pressure, the value of the bond will tank. This is one of the reasons I personally removed bonds from my portfolio.
In other words, when interest rates rise a bond or loan will become less valuable to the investor, but more valuable to the issuer. When you have a mortgage and the interest rate is rising, it’s good to not pay it off. Because if you have to refinance later, you will pay a higher rate. The mortgage you have, or the shorted bond, will become more valuable to you in an environment with rising interest rates.
Don’t Pay Off the Mortgage, Invest in Bonds and Live for Free!
Instead of paying down your mortgage, you could invest in safe bonds. By buying bonds, or going long, you will bring the net exposure to bonds closer to zero (remember: a mortgage is a short bond).
If you invest as much in bonds as you are in debt, you have a net neutral position regarding bonds. This works brilliantly when the yield on your bonds is close to the net interest rate you pay on your mortgage. You will live practically for free, with the bond yield paying your mortgage interest.
Read more: investment advertisements are predicting a crash.
Regarding cash flow, this works out the same as paying down your mortgage. However, your liquidity will be much better. If you pay off your house, you will have no debt but also no money. Then when you need money, you will have to remortgage your home.
If you invested in bonds instead, using the cashflow to make your mortgage payments, you will have a lot of money available to you. If you need money, you just have to sell (a portion of) your bonds. In this scenario you also live for free. Yes, you are exposed to an interest rate risk, but isn’t that the same with remortgaging your home in the other scenario?
Of course, not a lot of people will be able to do this. Especially not in developed Europe, where bond yields are extremely low. This strategy only works if your mortgage rate is lower than the yield on bonds so currently it can be hard.
Would you consider to invest in bonds instead of paying off your mortgage?